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Tuesday, April 29, 2008

I believe the outlines of the bust are becoming as visible as the bubble itself was to any astute observer a few years ago. But no bottom yet! If I had to guess, I'd say we are going to give back most of the integral over the curve from 1997 to 2007 or so, net of overall inflation during that period (say 20-30%). In other words, extend the blue trend line beyond the early nineties, and integrate your favorite curve minus this trend line from 1997-2007 to get the overvaluation. (Note the graph is of year over year price changes in nominal dollars, not absolute price.)

Or, just look at the figure below to see that prices might have to drop 30-40% to return to consistency with the long term trend.

As we've discussed before, house price increases tend to be quite modest if measured in real dollars. (Except, of course, for bubbles and special cases :-)

The Case-Shiller national index will probably be off close to 12% YoY (will be released in earlylate May). Currently (as of Q4) the national index is off 10.1% from the peak.

The composite 10 index (10 large cities) is off 13.6% YoY. (15.8% from peak)

To get a feel for the reaction of average Chinese towards criticism from the West, read the excerpt below from a poem now circulating on the internet. (See also video version at bottom.) If you are not familiar with some of the historical references, you might ask someone like Howard Zinn to explain them to you.

Most Chinese are incredulous that european colonialists and imperialists, many inhabiting the lands of indigenous people exterminated or displaced only a few centuries ago, would think to assume the moral high ground.

A POEM TO THE WEST by Anonymous

...When we closed our doors, You smuggled drugs to open markets.

When we embrace Free Trade, You blame us for taking away your jobs.

When we were falling apart, You marched in your troops and wanted your fair share.

When we tried to put the broken pieces back together again, Free Tibet you screamed, It was an Invasion!

When we tried Communism, You hated us for being Communist.

When we embrace Capitalism, You hate us for being Capitalist.

When we had a billion people, You said we were destroying the planet.

When we tried limiting our numbers, You said we abused human rights.

When we were poor, You thought we were dogs.

When we loan you cash, You blame us for your national debts.

When we build our industries, You call us Polluters.

When we sell you goods, You blame us for global warming.

When we buy oil, You call it exploitation and genocide.

When you go to war for oil, You call it liberation. ...

This NYTimes article and this Time magazine blog post are good examples of how poorly the Chinese worldview is understood here.

The poem was erroneously attributed to Dou-Liang Lin, an emeritus professor of physics at SUNY Buffalo. Professor Lin writes that he is not the author and doesn't know who is.

On 4/25/2008 at 7:56 AM, Duoliang Lin wrote:

Dear Friends,

Thank you for your enthusiastic praise and support. Several of you have asked for my authorization for translation into Chinese and/or reprinting. Since this was an anonymous poem circulating in the email, I suppose that the author would not mind to be quoted, translated or reprinted. But I was not the author of the poem. Please see below.

This is to clarify that the poem circulated in the email recently was not my work. I received it via email last week. There was no author shown. I read it with great interest and was impressed very much. I then decided to share it with my friends through my email network. Apparently some of them forwarded it to their friends, and in a few days, it has reached a large number of readers. Because my email is set with a signature block, some of the recipients assumed that I was the author. This is a misunderstanding and I should not be credited for its success.

I appreciate compliments from many within the last few days, but I must say that I am not the one to be credited. I am trying to trace back the email routes to see if I can find the original author.

I was informed today that it was also quoted in Wall Street Journal: There has been a poem by an anonymous author circulating in the internet recently. I feel relieved because I was not cited as the author. Thank you for your attention.

DL

Here is a nice observation, originally due to Henry Kissinger, which appeared in the comments below:

...America needs to understand that a hectoring tone evokes in China memories of imperialist condescension and is not appropriate in dealing with a country that has managed 4,000 years of uninterrupted self-government.

As a new century begins, the relations between China and the United States may well determine whether our children will live in turmoil even worse than the 20th century or whether they will witness a new world order compatible with universal aspirations for peace and progress.

Sunday, April 27, 2008

According to his estimates (see below), housing starts would have to go to zero (he gives a normal value of 600k per annum, but I think the correct number is about twice that) for several years to compensate for the inventory that will flood the market due to foreclosures. So, no recovery in the near future, and continued pressure on the dollar. He also has some nice things to say about academic economics :-)

Judy Woodruff: You write in your new book, The New Paradigm for Financial Markets,[1] that "we are in the midst of a financial crisis the likes of which we haven't seen since the Great Depression." Was this crisis avoidable?

George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.

Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.

There are now, for example, complex forms of investment such as credit-default swaps that make it possible for investors to bet on the possibility that companies will default on repaying loans. Such bets on credit defaults now make up a $45 trillion market that is entirely unregulated. It amounts to more than five times the total of the US government bond market. The large potential risks of such investments are not being acknowledged.

Woodruff: How can so many smart people not realize this?

Soros: In my new book I put forward a general theory of reflexivity, emphasizing how important misconceptions are in shaping history. So it's not really unusual; it's just that we don't recognize the misconceptions.

Woodruff: Who could have? You said it would have been avoidable if people had understood what's wrong with the current system. Who should have recognized that?

Soros: The authorities, the regulators—the Federal Reserve and the Treasury—really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.

Woodruff: The chairman of the Fed, Mr. Bernanke? His predecessor, Mr. Greenspan?

Soros: All of the above. But I don't hold them personally responsible because you have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking.

Woodruff: How much worse do you anticipate things will get?

Soros: Well, you see, as my theory argues, you can't make any unconditional predictions because it very much depends on how the authorities are going to respond now to the situation. But the situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot. They overshot on the upside and now they are going to overshoot on the downside.

Woodruff: You say the housing crisis is going to get much worse. Do you anticipate something like the government setting up an agency or a trust corporation to buy these mortgages?

Soros: I'm sure that it will be necessary to arrest the decline because the decline, I think, will be much faster and much deeper than currently anticipated. In February, the rate of decline in housing prices was 25 percent per annum, so it's accelerating. Now, foreclosures are going to add to the supply of housing a very large number of properties because the annual rate of new houses built is about 600,000. There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years. And then you have the adjustable-rate mortgages and other flexible loans.

Problems with such adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years. Now, it takes time before a foreclosure actually is completed. So right now you have perhaps no more than 10,000 to 20,000 houses coming into the supply on the market. But that's going to build up. So the idea that somehow in the second half of this year the economy is going to improve I find totally unbelievable.

...

Woodruff: When you talk about currency you have more than a little expertise. You were described as the man who broke the Bank of England back in the 1990s. But what is your sense of where the dollar is going? We've seen it declining. Do you think the central banks are going to have to step in?

Soros: Well, we are close to a tipping point where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.

I don't believe that quantum computers will work as designed, e.g., sufficiently large algorithms or subsystems will lead to real (truly irreversible) collapse. Macroscopic superpositions larger than whatever was done in the lab last week are impossible.

QM is only an algorithm for computing probabilities -- there is no reality to the quantum state or wavefunction or description of what is happening inside a quantum computer.

Wednesday, April 23, 2008

A couple of years ago I gave a talk at the Institute for Quantum Information at Caltech about the origin of probability -- i.e., the Born rule -- in many worlds ("no collapse") quantum mechanics. It is often claimed that the Born rule is a consequence of many worlds -- that it can be derived from, and is a prediction of, the no collapse assumption. However, this is only true in a particular limit of infinite numbers of degrees of freedom -- it is problematic when only a finite number of degrees of freedom are considered.

After the talk I had a long conversation with John Preskill about many worlds, and he pointed out to me that both Feynman and Gell-Mann were strong advocates: they would go so far as to browbeat visitors on the topic. In fact, both claimed to have invented the idea independently of Everett.

Today I noticed a fascinating paper on the arXiv posted by H.D. Zeh, one of the developers of the theory of decoherence:

Feynman's quantum theory

H. D. Zeh

(Submitted on 21 Apr 2008)

A historically important but little known debate regarding the necessity and meaning of macroscopic superpositions, in particular those containing different gravitational fields, is discussed from a modern perspective.

The discussion analyzed by Zeh, concerning whether the gravitational field need be quantized, took place at a relativity meeting at the University of North Carolina in Chapel Hill in 1957. Feynman presents a thought experiment in which a macroscopic mass (source for the gravitational field) is placed in a superposition state. One of the central points is necessarily whether the wavefunction describing the macroscopic system must collapse, and if so exactly when. The discussion sheds some light on Feynman's (early) thoughts on many worlds and his exposure to Everett's ideas, which apparently occurred even before their publication (see below).

Nowadays no one doubts that large and complex systems can be placed in superposition states. This capability is at the heart of quantum computing. Nevertheless, few have thought through the implications for the necessity of the "collapse" of the wavefunction describing, e.g., our universe as a whole. I often hear statements like "decoherence solved the problem of wavefunction collapse". I believe that Zeh would agree with me that decoherence is merely the mechanism by which the different Everett worlds lose contact with each other! (And, clearly, this was already understood by Everett to some degree.) Incidentally, if you read the whole paper you can see how confused people -- including Feynman -- were about the nature of irreversibility, and the difference between effective (statistical) irreversibility and true (quantum) irreversibility.

Zeh: ... Quantum gravity, which was the subject of the discussion, appears here only as a secondary consequence of the assumed absence of a collapse, while the first one is that "interference" (superpositions) must always be maintained. ... Because of Feynman's last sentence it is remarkable that neither John Wheeler nor Bryce DeWitt, who were probably both in the audience, stood up at this point to mention Everett, whose paper was in press at the time of the conference because of their support [14]. Feynman himself must have known it already, as he refers to Everett's "universal wave function" in Session 9 – see below.

... Toward the end of the conference (in the Closing Session 9), Cecile DeWitt mentioned that there exists another proposal that there is one "universal wave function". This function has already been discussed by Everett, and it might be easier to look for this "universal wave function" than to look for all the propagators. Feynman said that the concept of a "universal wave function" has serious conceptual difficulties. This is so since this function must contain amplitudes for all possible worlds depending on all quantum-mechanical possibilities in the past and thus one is forced to believe in the equal reality [sic!] of an infinity of possible worlds.

Well said! Reality is conceptually difficult, and it seems to go beyond what we are able to observe. But he is not ready to draw this ultimate conclusion from the superposition principle that he always defended during the discussion. Why should a superposition not be maintained when it involves an observer? Why “is” there not an amplitude for me (or you) observing this and an amplitude for me (or you) observing that in a quantum measurement – just as it would be required by the Schrödinger equation for a gravitational field? Quantum amplitudes represent more than just probabilities – recall Feynman’s reply to Bondi’s first remark in the quoted discussion. However, in both cases (a gravitational field or an observer) the two macroscopically different states would be irreversibly correlated to different environmental states (possibly including you or me, respectively), and are thus not able to interfere with one another. They form dynamically separate “worlds” in this entangled quantum state.

... Feynman then gave a resume of the conference, adding some "critical comments", from which I here quote only one sentence addressed to mathematical physicists:

Feynman: "Don't be so rigorous or you will not succeed."

(He explains in detail how he means it.) It is indeed a big question what mathematically rigorous theories can tell us about reality if the axioms they require are not, or not exactly, empirically founded, and in particular if they do not even contain the most general axiom of quantum theory: the superposition principle. It was the important lesson from decoherence theory that this principle holds even where it does not seem to hold. However, many modern field theorists and cosmologists seem to regard quantization as of secondary or merely technical importance (just providing certain "quantum corrections") for their endevours, which are essentially performed by using classical terms (such as classical fields). It is then not surprising that the measurement problem never comes up for them. How can anybody do quantum field theory or cosmology at all nowadays without first stating clearly whether he/she is using Everett’s interpretation or some kind of collapse mechanism (or something even more speculative)?

Tuesday, April 22, 2008

Moody's walks Roger Lowenstein (writing for the Times Sunday magazine) through the construction, rating and demise of a pool of subprime mortgage securities. Some readers may have thought the IMF was exaggerating when it forecast up to $1 trillion in future losses from the credit bubble. After reading the following you will see that it's not an implausible number, and it will be clear why the system is paralyzed in dealing with (marking to market) the complicated securities (CDOs, etc.) that are contaminating the balance sheets of banks, investment banks, hedge funds, pension funds, sovereign wealth funds, etc. around the world.

Here's a quick physicist's calculation: roughly 10 million houses sold per year, assume that 10% of these mortgages are bad and will cost the issuer $100k to foreclose and settle. That means $100B per year in losses. Over the whole bubble, perhaps $300-500B in losses, which is more or less what the IMF estimates as the residential component of credit bubble losses (the rest of the trillion comes from commercial and corporate lending and consumer credit).

The internet bubble, with irrational investors buying shares of pet food e-commerce companies, was crazy. Read the excerpts below and you'll see that our recent housing boom was even crazier and at an unimaginably larger scale. (Note similar bubbles in the UK, Spain and in China.)

The best predictor, going forward, of mortgage default rates (not just subprime, but even prime mortgages) in a particular region will likely be the decline in home prices in that region. The incentive for a borrower to default on his or her mortgage is the amount by which they are "upside down" on the loan -- the amount by which their indebtedness exceeds the value of the home. Since we can't forecast price declines very well -- indeed, it's a nonlinear problem, with more defaults leading to more price declines, leading to more defaults -- we can't price the derivative securities built from those mortgages.

Efficient markets! ;-)

The figure above compares Case-Shiller data on the current bust (magenta) to the bust of the 80s-90s (blue). (Click for larger version.) You can see we have some way to go before all the fun ends.

Gekko: Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies and cuts through and captures the essence of evolutionary spirit. Greed in all of its forms, greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.

Gekko: The richest one percent of this country owns half our country's wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It's bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.

Carl Fox: Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others.

NYTimes: ...The business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.

Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”

The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.

Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.

On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

Another factor giving Moody’s comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.

The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.

It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.

Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”

Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s. C.D.O.’s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies’ role was just as central. The difference is that XYZ was a first-order derivative — its assets included real mortgages owned by actual homeowners. C.D.O.’s were a step removed — instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.’s squared, which bought bonds issued by other C.D.O.’s.)

Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.’s that purchased them.

Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

...The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

...From 2002 to 2006, Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody’s reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, “I firmly believe that Moody’s business stands on the ‘right side of history’ in terms of the alignment of our role and function with advancements in global capital markets.”

...Moody’s was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.

XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZ fell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)

Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.

By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)

In April 2007, Moody’s announced it was revising the model it used to evaluate subprime mortgages. It noted that the model “was first introduced in 2002. Since then, the mortgage market has evolved considerably.” This was a rather stunning admission; its model had been based on a world that no longer existed.

Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners’ equity had never been as high as believed because appraisals had been inflated.

Over the summer and fall of 2007, Moody’s and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A’s.

The pain didn’t stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody’s rated C.D.O.’s without knowing which bonds the pool would buy.

A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. “We’re structure experts,” Yuri Yoshizawa, the head of Moody’s’ derivative group, explained. “We’re not underlying-asset experts.” They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.

Moody’s rated three-quarters of this C.D.O.’s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation — as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren’t like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody’s structured-finance division, remarks, it was “like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” And second, the bonds weren’t random. Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.’s have suffered similar fates (most of Wall Street’s losses have been on C.D.O.’s). For Moody’s and the other rating agencies, it has been an extraordinary rout.

...The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether. ...

Monday, April 21, 2008

In an earlier post I discussed a survey of honors college students here at U Oregon, which revealed that very few had a good understanding of elite career choices outside of the traditional ones (law, medicine, engineering, etc.). It's interesting that, in the past, elite education did not result in greater average earnings once SAT scores are controlled for (see below). But I doubt that will continue to be the case today: almost half the graduating class at Harvard now head into finance, while the top Oregon students don't know what a hedge fund is.

NYTimes: ...Recent research also suggests that lower-income students benefit more from an elite education than other students do. Two economists, Alan B. Krueger and Stacy Berg Dale, studied the earnings of college graduates and found that for most, the selectivity of their alma maters had little effect on their incomes once other factors, like SAT scores, were taken into account. To use a hypothetical example, a graduate of North Carolina State who scored a 1200 on the SAT makes as much, on average, as a Duke graduate with a 1200. But there was an exception: poor students. Even controlling for test scores, they made more money if they went to elite colleges. They evidently gained something like closer contact with professors, exposure to new kinds of jobs or connections that they couldn’t get elsewhere.

“Low-income children,” says Mr. Krueger, a Princeton professor, “gain the most from going to an elite school.”

I predict that, in the future, the returns to elite education for the middle and even upper middle class will resemble those in the past for poor students. Elite education will provide the exposure to new kinds of jobs or connections that they couldn't get elsewhere. Hint: this means the USA is less and less a true meritocracy.

It's also interesting how powerful the SAT (which correlates quite strongly with IQ, which can be roughly measured in a 12 minute test) is in predicting life outcomes: knowing that a public university grad scored 99th percentile on the SAT (or brief IQ test) tells you his or her expected income is equal to that of a Harvard grad (at least that was true in the past). I wonder why employers (other than the US military) aren't allowed to use IQ to screen employees? ;-) I'm not an attorney, but I believe that when DE Shaw or Google ask a prospective employee to supply their SAT score, they may be in violation of the law.

Saturday, April 19, 2008

Take with boulder-sized grain of salt. Cause and effect? Only an eight day interval? Couldn't that have been an exceptional period over which aggressiveness paid off?

NYTimes: MOVEMENTS in financial markets are correlated to the levels of hormones in the bodies of male traders, according to a study by two researchers from the University of Cambridge (newscientist.com).

John Coates, a research fellow in neuroscience and finance, and Joe Herbert, a professor of neuroscience, sampled the saliva of 17 traders on a stock trading floor in London two times a day for eight days. They matched the men’s levels of testosterone and cortisol with the amounts of money the men lost or won on the markets. Men with elevated levels of testosterone, a hormone associated with aggression, made more money. When the markets were more volatile, the men showed higher levels of cortisol, considered a “stress hormone.”

But, as New Scientist asked, “which is the cause and which is the effect?”

According to the researchers’ analysis, the men who began their workdays with high levels of testosterone did better than those who did not.

“The popular view is that experienced traders can control their emotions,” Mr. Coates told New Scientist. “But, in fact, their endocrine systems are on fire.”

As with anything else, when it comes to hormones, it is possible to have (from a trader’s perspective) too much of a good thing. Excessive testosterone levels can lead a trader to make irrational decisions.

New Scientist pointed out that although cortisol can help people make more rational decisions during volatile trading periods, too much of it can lead to serious health problems like heart disease and arthritis, and, over time, diminish brain functions like memory.

If individual traders are affected by their hormone levels, does the same hold true for the markets as a whole? After all, the market is nothing more than an aggregate of the individual actions of traders. Mr. Coates thinks it is possible that “bubbles and crashes are coming from these steroids,” according to New Scientist.

If so, “central banks may lower interest rates only to find that traders still refuse to buy risky assets.”

Perhaps, he told New Scientist, “if more women and older men were trading, the markets would be more stable.”

Wednesday, April 16, 2008

Having played a lot of sports and done a lot of physical training, it's not often that I see something in the gym that shocks me.

But recently I came across the Crossfit training system. It's based around short, hyper intense workouts using basic bodyweight gymnastic moves (pushups, pullups, burpees, rope climbing), olympic and power lifts (cleans, jerks, presses, squats) and track sprints and rowing. The goal is to engage the large muscle groups and push them to both anaerobic and aerobic failure at the same time. For experienced athletes, the idea of using olympic lifts for cardiovascular stress training seems over the top, but anyone who can survive this is going to get very, very fit.

The founder of Crossfit, former gymnast Greg Glassman, is the guru behind this movement. He rails against bodybuilders who lack functional strength, and runners, cyclists and triathletes who are so specialized that they lack overall athleticism. (He doesn't have any bad words for ultimate fighters, though, some of whom use his system :-) The point I think Glassman overlooks is that the traditional training methods are meant to minimize injury and allow regular performance by an average person. It's telling that Glassman, 49, doesn't Crossfit train anymore. (See this NYTimes profile from a few years ago; the followup reader discussion is very good.)

If you have any athletic background at all (endurance training doesn't count -- it's gotta be something with a little explosiveness and testosterone ;-), watch the videos and tell me you are not freaked out.

Coach Glassman: The popular media, commercial gyms, and general public hold great interest in endurance performance. Triathletes and winners of the Tour de France are held as paradigms of fitness. Well, triathletes and their long distance ilk are specialists in the word of fitness and the forces of combat and nature do not favor the performance model they embrace. The sport of competitive cycling is full of amazing people doing amazing things, but they cannot do what we do. They are not prepared for the challenges that our athletes are. The bodybuilding model of isolation movements combined with insignificant metabolic conditioning similarly needs to be replaced with a strength and conditioning model that contains more complex functional movements with a potent systemic stimulus. Sound familiar? Seniors citizens and U.S. Marine Combatant Divers will most benefit from a program built entirely from functional movement.

CFJ: What about aerobic conditioning?

Coach Glassman: I know you’re messing with me – trying to get me going. Look, why is it that a 20 minute bout on the stationery bike at 165 bpm is held by the public to be good cardio vascular work, whereas a mixed mode workout keeping athletes between 165-195 bpm for twenty minutes inspires the question, ”what about aerobic Conditioning?” For the record, the aerobic conditioning developed by CrossFit is not only high-level, but more importantly, it is more useful than the aerobic conditioning that comes from regimens comprised entirely of monostructural elements like cycling, running, or rowing. Now that should start some fires! Put one of our guys in a gravel shoveling competition with a pro cyclist and our guy smokes the cyclist. Neither guy trains by shoveling gravel, why does the CrossFit guy dominate? Because CrossFit’s workouts better model high demand functional activities. Think about it – a circuit of wall ball, lunges and deadlift/highpull at max heart rate better matches more activities than does cycling at any heart rate.

This NYTimes article covers recent results in happiness research, which shows that money does buy happiness after all ;-) The new data seem to show a stronger correlation between average happiness and economic development than earlier studies which had led to the so-called Easterlin paradox. One explanation for the divergence between old and new data is that people around the world are now more aware of how others in developed countries live, thanks to television and the internet. That makes them less likely to be content if their per capita incomes are low (see the hedonic treadmill below). The old data showed surprisingly little correlation between average income and happiness, but 30-50 years ago someone living in Malawi might have been blissfully unaware of what he or she was missing. See the article for links to the research papers and a larger version of the figure. Also see these reader comments from the Times, which range from the "happiness is a state of mind" variety to "money isn't everything but it's way ahead of whatever is in second place."

In previous posts we've discussed the hedonic treadmill, which is based on the idea of habituation. If your life improves (e.g., move into a nicer house, get a better job, become rich), you feel better at first, but rapidly grow accustomed to the improvement and soon want even more. This puts you on a treadmill from which it is difficult to escape. The effect is especially pernicious if you adjust your perceived peer group as you progress (rivalrous thinking) -- there is always someone else who is richer and more successful than you are! Note, the hedonic treadmill is not inconsistent with an overall correlation between happiness and income or wealth. It just suggests diminishing returns due to psychological adjustment.

Monday, April 14, 2008

John Archibald Wheeler, one of the last great physicists of a bygone era, has died. He outlived most of his contemporaries (Bohr, Einstein, Oppenheimer) and even some of his students, like Feynman.

NYTimes: John A. Wheeler, a visionary physicist and teacher who helped invent the theory of nuclear fission, gave black holes their name and argued about the nature of reality with Albert Einstein and Niels Bohr, died Sunday morning at his home in Hightstown, N.J. He was 96.

...One particular aspect of Einstein’s theory got Dr. Wheeler’s attention. In 1939, J. Robert Oppenheimer, formerly the head of the Manhattan Project, and a student, Hartland Snyder, suggested that Einstein’s equations had made an apocalyptic prediction. A dead star of sufficient mass could collapse into a heap so dense that light could not even escape from it. The star would collapse forever while spacetime wrapped around it like a dark cloak. At the center, space would be infinitely curved and matter infinitely dense, an apparent absurdity known as a singularity.

Dr. Wheeler at first resisted this conclusion, leading to a confrontation with Dr. Oppenheimer at a conference in Belgium in 1958, in which Dr. Wheeler said that the collapse theory “does not give an acceptable answer” to the fate of matter in such a star. “He was trying to fight against the idea that the laws of physics could lead to a singularity,” Dr. Charles Misner, a professor at the University of Maryland and a former student, said. In short, how could physics lead to a violation itself — to no physics?

Dr. Wheeler and others were finally brought around when David Finkelstein, now an emeritus professor at Georgia Tech, developed mathematical techniques that could treat both the inside and the outside of the collapsing star.

At a conference in New York in 1967, Dr. Wheeler, seizing on a suggestion shouted from the audience, hit on the name “black hole” to dramatize this dire possibility for a star and for physics.

The black hole “teaches us that space can be crumpled like a piece of paper into an infinitesimal dot, that time can be extinguished like a blown-out flame, and that the laws of physics that we regard as ‘sacred,’ as immutable, are anything but,” he wrote in his 1999 autobiography, “Geons, Black Holes & Quantum Foam: A Life in Physics.” (Its co-author is Kenneth Ford, a former student and a retired director of the American Institute of Physics.)

In 1973, Dr. Wheeler and two former students, Dr. Misner and Kip Thorne, of the California Institute of Technology, published “Gravitation,” a 1,279-page book whose witty style and accessibility — it is chockablock with sidebars and personality sketches of physicists — belies its heft and weighty subject. It has never been out of print. ...

I mentioned the history of black holes in general relativity in an earlier post on J.R. Oppenheimer:

Perhaps most important was his work in the 1930's on the endpoint of stellar evolution, with his students Volkoff and Snyder at Berkeley. They explored many of the properties of black holes long before the term "black hole" was coined by Wheeler. Oppenheimer and company were interested in neutron star stability, and gave the first general-relativistic treatment of this complicated problem. In so doing, they deduced the inevitability of black hole formation for sufficiently massive progenitors. They also were the first to note that an infalling object hits the horizon after a finite proper time (in its own frame), whereas an observer orbiting the hole never actually sees the object hit the horizon. The work received amazingly little attention during Oppenheimer's life. But, had Oppenheimer lived another few decades, it might have won him a Nobel prize.

Friday, April 11, 2008

Looks like a fascinating documentary, profiling nine young people trying to make it in modern China. Among those profiled are a US-educated entrepreneur, a hip hop artist, an environmental lawyer and a migrant factory worker. It's meant to be a longitudinal study like Michael Apted'sUp series in the UK, so look for future installments. Interview with the filmmaker on the Leonard Lopate show. (I highly recommend Lopate's podcasts -- he's the sharpest interviewer I've found in arts, literature and contemporary culture. Not exactly your guy for science or economics, though.)

Losses from the credit crisis by financial institutions worldwide are expected to balloon to almost $1 trillion (£507 billion), threatening to trigger severe economic fallout, the International Monetary Fund said yesterday.

In a grim assessment of the deepening crisis delivered days before ministers from the Group of Seven leading economies meet in Washington, the IMF warns governments, central banks and regulators that they face a crucial test to stem the turmoil.

“The critical challenge now facing policymakers is to take immediate steps to mitigate the risks of an even more wrenching adjustment,” it says in its twice-yearly Global Financial Stability Report.

The IMF sounds an alert over the danger that banks’ escalating losses, along with credit market uncertainties, could prompt a vicious downward spiral as they weaken economies and asset prices, leading to higher unemployment, more loan defaults and still deeper losses. “This dynamic has the potential to be more severe than in previous credit cycles, given the degree of securitisation and leverage in the system,” the Fund argues.

It says that it is clear that global financial upheavals are now more than just a shortage of ready funds, or liquidity, but are rooted in “deep-seated fragilities” among banks with too little capital. This “means that its effects are likely to be broader, deeper and more protracted”, the report concludes.

“A broadening deterioration of credit is likely to put added pressure on systemically important financial institutions,” it adds, saying that the risks have increased of a full-blown credit crunch that could undercut economic growth.

The warning came as Kenneth Rogoff, a former chief economist at the IMF and currently Professor of Economics at Harvard University, said that there was a “likely possibility” that the Fund will have to coordinate a global policy package to prop up the US economy. “They [the US] would not go for a conventional bail-out from the IMF. The IMF could not afford it – they have around $200 billion, which the US would burn through in a matter of months. It would be a package where various countries would try and prop up global demand to cushion the US economy.” He added: “The US is going to be looking for help to prevent this banking and housing problem from getting worse.”

The report also highlights the threat posed by the rapid spread of the credit crisis from its roots in the US sub-prime home loans to more mainstream lending markets worldwide.

While banks have so far declared losses and writedowns over the crisis totalling $193 billion, the IMF expects the ultimate toll to reach $945 billion.

Global banks are expected to shoulder about half of the total losses – between $440 and $510 billion – with the rest being borne by insurance companies, pension funds, hedge funds and money market funds, and other institutional investors, predominantly in the US and Europe.

Most of the losses are expected to stem from defaults in the US, with $565 billion written off in sub-prime and prime mortgages and a further $240 billion to be lost on commercial property lending. Losses on corporate loans are projected to mount to an eventual $120 billion and those on consumer lending to $20 billion.

Monday, April 07, 2008

Alpha magazine has a long article on the current state of quant finance. It may be sample bias, but former theoretical physicists predominate among the fund managers profiled.

I've always thought theoretical physics was the best training for applying mathematical techniques to real world problems. Mathematicians seldom look at data, so are less likely to have the all-important intuition for developing simple models of messy systems, and for testing models empirically. Computer scientists generally don't study the broad variety of phenomena that physicists do, and although certain sub-specialties (e.g., machine learning) look at data, many do not. Some places where physics training can be somewhat weak (or at least uneven) include statistics, computation, optimization and information theory, but I've never known a theorist who couldn't pick those things up quickly.

Physicists have a long record of success in invading other disciplines (biology, computer science, economics, engineering, etc. -- I can easily find important contributions in those fields from people trained in physics, but seldom the converse). Part of the advantage might be pure horsepower -- the threshold for completing a PhD in theoretical physics is pretty high. However, a colleague once pointed out that the standard curriculum of theoretical physics is basically a collection of the most practically useful mathematical techniques developed by man -- the high points and greatest hits! Someone trained in that tradition can't help but have an advantage over others when asked to confront a new problem.

Having dabbled in fields like finance, computer science and even biology, I've come to consider myself as a kind of applied mathematician (someone who applies mathematical ideas to the real world) who happens to have had most of his training from working on physical systems. I suspect that physicists who have left the field, as well as practitioners of biophysics, econophysics, etc. might feel the same way.

Readers of this blog sometimes accuse me of a negative perspective towards physics. Quite the contrary. Although I might not be optimistic about career prospectswithin physics, or the currentstate of the field, I can't think of any education which gives a richer understanding of the world, or a greater chance of contributing to it.

...Finkelstein, who also grew up in Kharkov, has a Ph.D. in theoretical physics from New York University and a master’s degree in the same discipline from the Moscow Institute of Physics and Technology. Before joining Horton Point as chief science officer, he was head of quantitative credit research at Citadel Investment Group in Chicago.

Most of the 12 Ph.D.s at Horton Point’s Manhattan office are researching investment strategies and ways to apply scientific principles to finance. The firm runs what Finkelstein, 54, describes as a factory of strategies, with new models coming on line all the time. “It’s not like we plan to build ten strategies and sit on them,” he says. “The challenge is to keep it going, to keep this factory functioning.”

Along with his reservations about statistical arbitrage, Sogoloff is wary of quants who believe the real world is obliged to conform to a mathematical model. He acknowledges the difficulty of applying scientific disciplines like genetics or chaos theory — which purports to find patterns in seemingly random data — to finance. “Quantitative work will be much more rewarding to the scientist if one concentrates on those theories or areas that attempt to describe nonstable relationships,” he says.

Sogoloff sees promise in disciplines that deal with causal relationships rather than historical ones — like mathematical linguistics, which uses models to analyze the structure of language. “These sciences did not exist five or ten years ago,” he says. “They became possible because of humongous computational improvements.”

However, most quant shops aren’t exploring such fields because it means throwing considerable resources at uncertain results, Sogoloff says. Horton Point has found a solution by assembling a global network of academics whose research could be useful to the firm. So far the group includes specialists in everything from psychology to data mining, at such schools as the Beijing Institute of Technology, the California Institute of Technology and Technion, the Israel Institute of Technology.

Sogoloff tells the academics that the goal is to create the Bell Labs of finance. To align both parties’ interests, Horton Point offers them a share of the profits should their work lead to an investment strategy. Scientists like collaborating with Horton Point because it combines intellectual freedom with the opportunity to test their theories using real data, Sogoloff says. “You have experiments that can be set up in a matter of seconds because it’s a live market, and you have the potential for an amazing economic benefit.” ...

Friday, April 04, 2008

Here is a 40 minute discussion of the credit crisis on NPR's Fresh Air. The "expert" is a law professor with a tenuous grasp of finance, a love of regulation and an axe to grind against Wall St. and former Senator Phil Gramm. Terri Gross, ordinarily an astute interviewer, can't seem to get beyond concepts like big bets at a big casino by unregulated fat cats. 8-/

Tuesday, April 01, 2008

I donated a number of shares in my previous startup (SafeWeb, Inc., acquired by Symantec in 2003) to endow a permanent undergraduate scholarship in memory of my father. In the course of setting up the scholarship I had to assemble a brief bio of my dad, which I thought I would post here on the Internet, to preserve for posterity.

The first recipient of the scholarship was a student from Shanghai, who had won a gold medal in the International Physics Olympiad. The second recipient was a woman from Romania. I encourage all of my friends in the worlds of technology and finance to give back to the institutions from which they received their educations.

Cheng Ting Hsu Scholarship

This scholarship was endowed on behalf of Cheng Ting Hsu by his son Stephen Hsu, Caltech class of 1986. It is to be awarded in accordance with Institute policies to the most qualified international student each year. Preference is to be given to applicants from Chinese-speaking countries: China (including Hong Kong), Taiwan and Singapore. Also, preference should be given, if possible, to those with outstanding academic qualifications (such as, but not limited to, performance in national-level competitions in math, physics or computer science or other similar distinction).

If the recipient is a continuing (rather than incoming) student, academic qualification can be based on GPA at Caltech, or other outstanding performance (such as, but not limited to, performance on competitive exams such as those in computer programming or mathematics, or outstanding research work).

Cheng Ting Hsu was born December 1, 1923 in Wenling, Zhejiang province, China. His grandfather, Zan Yao Hsu was a poet and doctor of Chinese medicine. His father, Guang Qiu Hsu graduated from college in the 1920's and was an educator, lawyer and poet. Cheng Ting was admitted at age 16 to the elite National Southwest Unified University, which as created during WWII by merging Tsinghua, Beijing and Nankai Universities. This university produced numerous famous scientists and scholars such as the physicists C.N. Yang and T.D. Lee. Cheng Ting studied aerospace engineering (originally part of Tsinghua), graduating in 1944. He became a research assistant at China's Aerospace Research Institute and a lecturer at Sichuan University. He also taught aerodynamics for several years to advanced students at the air force engineering academy.

In 1946 he was awarded one of only two Ministry of Education fellowships in his field to pursue graduate work in the United States. In 1946-1947 he published a three-volume book, co-authored with Professor Li Shoutong on the structures of thin-walled airplanes. In January, 1948, he left China by ocean liner, crossing the Pacific and arriving in San Francisco. In March of 1948 he began graduate work at the University of Minnesota, receiving his masters degree in 1949 and PhD in 1954. During this time he was also a researcher at the Rosemount Aerospace Research Institute in Minneapolis.

In 1958 Cheng Ting was appointed associate professor of aerospace engineering at Iowa State University. He was one of the founding faculty members of the department and became a full professor in 1962. During his career he supervised about 30 Masters theses and PhD dissertations. His research covered topics including jet propulsion, fluid mechanics, supersonic shock waves, combustion, magneto-hydrodynamics, vortex dynamics (tornados) and alternative energy (wind turbines). He published widely, in scientific journals ranging from physics to chemistry and aerodynamics.

Professor Hsu retired from Iowa State University in 1989 due to ill health, becoming Professor Emeritus. He passed away in 1996.